By Tyler Durden
This week, Raoul Pal, founder of Real Vision TV and Global Macro Investor, joined the MacroVoices podcast for a full-length feature interview wherein he sweeps through a plethora of convergent global financial issues. In addition to his thoughts on his long U.S. dollar thesis, the recent sell-off in bonds, gold, central bank policy, and soft commodities, Pal explains why the crumbling European banking system, within a slumping global business cycle, is the biggest systemic risk yet. This is an interview you don’t want to miss. The episode starts with a weekly market summary and the interview begins at 13:30, which is summarized below.
“There are interesting things happening in the LIBOR and Eurodollar funding markets, which means that U.S. interest rates have shot higher and the interest rate differential between the US and Europe would suggest that something like the Euro should go back to parity. I still think the balance of probabilities lies with the fact this is still a pause in the dollar rally and the dollar goes much higher over time. In a situation where the global and US economy slows, I think the dollar goes higher because US rates are still relatively high and there is more opportunity, on a relative basis. As rates get cut around the world, which I think they will do at some point, the interest rate differentials mean that if the US is bad, the rest of the world is worse, so the dollar goes higher. And this [Libor and Eurodollar] funding issue means it’s very hard to get a hold of dollars outside of the US and that’s creating a problem where we could see some real pressure on people who borrow dollars and need to pay some of it back.“
When Townsend follows up with what some think is the Fed’s inevitable rate-hiking U-turn, and how the next rate cut would put downward pressure on the dollar, Pal acknowledges the possibility but opines that Fed spectators are missing the point:
“People are confusing the dollar price-action only with the fact the Fed is hiking rates. I think it’s a much more structural issue, as I’ve talked about in the past, the $10 trillion short position that’s out there and the fundamental pressures on those short positions mean that regardless of what happens to interest rates, the dollar goes higher. But I do think very much so that there is a risk that as the Fed starts coming out of the [tightening] equation, the dollar weakens back down to the range – it’s possible we get a false break lower – but the next larger, 10-point move [in the DXY] is higher.”
On the recent sell-off in Treasuries, Pal saw this as the market working-out an over-crowded trade ahead of a recession and sees rising yields as a potential opportunity once the business cycle finally turns lower. To Pal, the next recession, as far as bond yields are concerned, will be no different and “there’s no reason to believe that in a recession 10-year yields wouldn’t get down to 50bps – we’ve seen it absolutely everywhere else in the developed world and there’s no reason the US escapes it.”
Moving to Pal’s use of the business cycle to forecasts recessions, he lays bear the evidence for the fact that we might already be in one. To wit, “whether its the retail sector, restaurants, durable goods, freight, world trade – most of these things are all in recession now and there are very few areas of the U.S. economy and the global economy that aren’t in recession.”
For the unconvinced, Pal brings to attention a relationship between presidential elections and recessions that trump any economic indicator:
“The other thing to bear in mind is that, I went back into every single two-term presidential election (i.e. when the incumbent changes) and there is a 100% track record of a recession within the next 12 months. It either starts just beforehand or starts afterward, but within 12 months there is a 100% chance of a recession.”
After touching on the political contagion spreading from Brexit to the rest of Europe, Townsend and Pal discuss the risk-parity bloodshed as of late and other over-crowded trades that stand to amplify risk in a reflexive manner. Specifically, Pal expresses concern over pension funds selling volatility for yield and how it can end in tears, again, if the business cycle rolls-over decisively:
“I’m also concerned about the amount of VIX selling going on, the open interest in short positions in VIX futures is the highest in all recorded history. That’s coming from yield-enhancement trades by pension funds who are trying to pick up any yield they can and they think the smart way is to sell volatility. I think, obviously, that’s a pretty dangerous trade because if volatility explodes, everyone’s got a margin call and actually they end up selling equity and doing all the things they didn’t want to do because they thought they were going to be a buyer of equities into a dip. So, I think there is some concentration of positions and strategies that is not good, I also don’t like the fact that there is a lot of illiquidity and a lot of people are in illiquid strategies, which can all feed on itself. That being said, none of these are going to be meaningful unless the economic cycle is proven to be headed towards, or in, recession, in which case bad things tend to happen. If it’s not, and the economic cycle is still lackluster, but relatively expanding, then the chance of this being a short-scale event, which is what it looks like in the bond market right now, is more likely.”
Shifting over to gold, Pal lightened on his shorter-term positions at the beginning of September, noting the correlation with higher bond yields. However, negative interest rates continue to drive his thesis on gold:
“My thesis for owning gold over this period was that negative rates meant that gold was becoming more attractive over time. The long-term story of gold and fiat currencies, we all understand that one, but really for me the main driver was going to be negative interest rates and if I thought bond yields were going back up, which they have done, I thought gold would come lower, which it has done. Now, I think both of those stated affairs are temporary – can gold go a little bit lower, possibly. Or is this a tight-wedge forming and it breaks higher, that’s probably true too. I’m actually long gold versus the dollar and I’m also long gold versus a basket of global currencies, two different ways of having that trade on.”
Pal then addressed Goldman’s recent note which cited subsiding Chinese, Japanese, and European volatility as one of the reasons for the sell-off in Treasuries. According to Pal, Goldman has it wrong and points to the U.S. dollar as the prime mover:
“I think [Goldman] is thinking about this the wrong way right now. The reason flight capital is subdued right now is because the dollar is subdued. If the dollar starts going higher, then suddenly the flight capital situation across the Southeast Asian and emerging markets increases again. I’ve just come back from Hong Kong last week, and most people there are pretty bullish on the region. When pushed as to why they’re bullish, they basically think that in the event of nothing happening, then emerging markets do okay. So, that’s the bullish thesis and then when I question them about what happens if the dollar goes up, they say all bets are off.
When it came to the Fed’s monetary policy and signaling of rate hikes, Pal opines that it’s difficult to figure out what they’re trying to do. Perhaps, “one thing that is useful is to try and create a positively-sloping yield curve, which is one of the things I think they’re trying to do, because that stops the banks from getting into a terrible mess.” But apart from saving the Fed’s shareholders, Pal finds it useful to take another approach:
For me, I tend to step back and filter out a lot of this noise out. A lot of people spend too long looking at the Fed. I look at the business cycle and understand what the Fed can and can’t do. So if I look at the business cycle again, the probability of them being able to do anything is pretty low. Therefore, it still makes me like bonds over time – it’s going to be fantastic setup in the bond market soon, as we talked about, to be long bonds and everybody is out of the trade, it’ll be a lovely clear position, economic weakness will be there, and the Fed won’t raise rates. Even if they do raise rates, the yield curve will flatten like crazy. I think the Fed is almost an irrelevance at this point.”
For Pal’s complete discussion on the European banking tire-fire, check out the full interview at MacroVoices.com. Below are exerts from that discussion:
“I noticed this maybe three years ago that Deutsche Bank was looking concerning when people were telling us everything was okay. The other one that didn’t look good was Credit Suisse, UBS was somewhat similar but that changed a little bit. Then it rolled into the Italian banks and back into the Spanish banks – nobody is talking about the Spanish banks. Some of those, maybe two months ago, hit new all-time lows again and yet nobody talks about a systemic problem in the Spanish banking system.
But if you look back and just kind of think about what’s going on, there is a big issue in the European banking system. Part of this is negative rates, banks can’t deal with negative rates. Secondly, it’s regulation, they can’t deal with regulation. Thirdly, it’s bad loans and they’ve got tons of them. Deutsche Bank, on the other hand, has enormous derivatives books, it’s got positions it can’t get rid of, it has problems with its collateral because it requires so much collateral for its derivatives on its books. It’s created distortions in the market, we’re seeing some huge distortions going on in Libor right now… But this story of what’s been going on with the tightness in the Eurodollar interest rate market has been going on for some time – that’s been driven by the European banks that are under tremendous funding pressure and it’s less and less easy for them to get money.
This is why some of the swap lines…were tapped in Japan recently, Europeans haven’t tapped the swap lines, but swap lines are in place with the Fed to try and supply dollars to the offshore market, the Eurodollar market because it’s really tight right now. What I have noticed is that as Libor, 3m Libor, 1y Libor keeps moving higher and higher every day right now, it has been highly correlated to firms like Deutsche Bank, because obviously the lower-credit banks find it harder and harder to borrow money.
Now, does this end up in a full-blown banking crisis? I don’t really know, but what I do know is that it’s unsustainable for the Italian banks and the Spanish banks, particularly, to continue falling as fast as they have. There are rumors swirling almost every day now that Deutsche Bank will get some kind of bail-out, whether the state will take them over, something will have to happen. But the problem is why I’m really interested in them is how the ECB, or the individual states, deal with a bail-out of a bank, because they claimed in a Cyprus situation that bail-ins was the way things were going to get done (i.e. the depositors lost their money). I’d love to see the Germans try to take depositor money away from Deutsche Bank. I don’t think they’ll allow it and this ties well into that story of Europe; how are you doing to hold it together when suddenly what was told to one country doesn’t apply to another, and in particular that country is Germany… Back to my key theme and how I look at the business cycle, bad things happen in recessions so if we are heading towards recession, the European economy is weakening, France is basically at recession, Italy is in recession, Germany is now weakening, Spain is looking okay. But if we start to weaken significantly, then the probability explodes of a bad thing happening, and a bad thing happening in Europe is two-fold: one is the banks and one is the political situation. People should not lose focus on this because it is a really big deal.“
It gets worse…
“I spent a long time looking into the clearing and custody system; the DTCC in America and Euroclear in Europe. Those government bonds that are at the heart of the derivatives industry, they’re the collateral for everything in the entire loan industry, those things are re-lent out something like 30 times in the system to allow for this leverage. The problem is nobody actually has full claim on the bonds within the custody system. So, if one of the countries in Europe defaults, or something happens where Santander goes bust and Spain goes bust on the same day, the systemic problems within the custody system and the derivative industry, all the collateral and settlements is beyond anybody’s imagination. The system cannot allow for there to be sovereign risk because if there is sovereign risk then there is no risk-free collateral, and that is a real issue and would break the entire global banking system in one day. Which is one of the reasons they were so careful back in 2012 not to let anyone technically default because had they done that, basically it takes down everything we know of as a banking system. We would have to reprice what we understand to be the risk-free rate, we wouldn’t have a risk-free rate.”
To cap off the feature interview, Pal discusses his bullish outlook for soft commodities based on changing climate patterns that will fundamentally affect supply and demand fundamentals, potentially decoupling from a stronger dollar’s gravitation pull. Pal also speaks to the coming initiatives for Real Vision TV as they seek to topple and revolutionize the legacy financial media.